AIG Ignores New Derivatives Protocol

The Financial Times is reporting AIG is ignoring the new rules on derivatives.

The unit that all but destroyed AIG has failed to sign up for the overhaul of the global derivatives market which was given added impetus by the troubles at the US insurance group.

AIG confirmed that its financial products unit, whose soured bets on credit default swaps forced the company into government hands last year, did not adopt the “Big Bang” protocol that has been signed by more than 2,000 market participants.

The protocol, created under the auspices of International Swaps & Derivatives Association, is intended to make it easier for investors in the opaque market for credit derivatives to know what will happen to their contracts if debt defaults occur. It came into force on Wednesday.

The Big Bang Protocol is a self-imposed intermediary step to create a standard for settling contracts. The idea is to move to a central clearing house to create transparency for derivatives.

Blogging Stocks says the big bang protocol is all smoke and mirrors anyway. He points to how this is only in the United States and applies not to CDOs, CLOs, but to CDSes.

While the blogging stocks article date is from April 8th, this bomb fact was also mentioned:

The Tri Optima, a trade processing group, said it has removed $5.5 trillion dollars of redundant contracts from the market in the first 3 months of the year. Let me say that again --$5.5 trillion dollars has simply evaporated.

Anyone else have some insight into $5.5. trillion of redundant contracts being removed please leave a comment.

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"Anyone else have some insight into $5.5. trillion of redundant contracts being removed please leave a comment."

It's just netting. The easiest way to exit a CDS position is to buy an offsetting CDS from a third party -- it's much easier than novating or terminating a CDS. Since the dealer banks generally carry matched books (i.e., net flat CDS books), for every CDS they sell to an end-user, they buy an offsetting CDS from another end-user. In reality, this offsetting CDS position will usually make its way around the dealers before finally ending up with another end-user. For example, JPM sells a CDS to an end-user, then buys an offsetting CDS from Morgan Stanley, who buys another offsetting CDS from Merrill, who buys an offsetting CDS from Goldman, who finally buys an offsetting CDS from MBIA (the ultimate end-user). All the trades between the dealers can be netted out -- that is, offsetting trades can be cancelled -- since they're really just superfluous, but there was a huge back-log of CDS trades at the dealer banks. This led to an enormous build-up in the "gross notional" CDS outstanding, but didn't represent the true risk in the CDS market (i.e., the "net notional" CDS outstanding).

The dealer banks only started to get serious about netting out all the back-logged CDS trades when Geithner, in his capacity as NY Fed President, told them to net out their CDS back-logs or face the wrath of the of the NY Fed (which, contrary to popular belief, was a very credible threat coming from Geithner). So the dealers eventually hired TriOptima to net out all their CDS books by matching up offsetting trades and cancelling them. That process dramatically reduces the gross notional CDS outstanding. That makes it look to naive journalists like $5.5 trillion "has simply evaporated," but in reality that risk was never there in the first place. The journalists only thought it was there because they don't understand the difference between "gross" and "net." According to the DTCC, the net notional CDS outstanding -- i.e., the true amount insured by the CDS market -- is only about $2.7 trillion.

Also, I don't know why anyone would be surprised that AIG didn't sign the Big Bang protocol. The Big Bang was for single-name CDS on corporate bonds, and AIG never really wrote single-name corporate CDS. AIG wrote CDS on ABS/CDOs, which are a completely different beast, and aren't covered by the Big Bang protocol.

OK, that was probably a longer explanation than you wanted, but the amount of misinformation in the press about the CDS market really irks me.

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